JPMorgan Almost Put $1.32 Billion in Bernie Madoff's Ponzi Scheme

NEW YORK (TheStreet) - When it came to Bernie Madoff, JPMorgan (JPM) got lucky its policy wasn't to do a $1 billion "trust me deal" with a felon who will rot in prison.

Documents released by The Department of Justice on Tuesday show that JPMorgan came alarmingly close to putting well-over $1 billion of the firm's own capital into Bernie Madoff's Ponzi scheme, just before its collapse.

JPMorgan, which was the primary banker to Madoff Securities between October 1986 and its collapse on Dec. 11, 2008, sought to create complicated derivative products that would provide its private banking clients exposure to the $65 billion Ponzi scheme, according to documents released on Tuesday.

Beginning in the spring of 2006, JPMorgan invested roughly $343 million of the firm's own money in feeder funds to Madoff as a means to create a business of selling structured equity derivative products mimicking the Ponzi scheme's investment performance.

With some money invested in Madoff feeder funds, JPMorgan sought to create products that would mimic the consistent returns of Madoff's investment performance through a synthetic exposure that didn't actually require entry to the Ponzi scheme artist's financial universe.

The derivatives, known as equity total return swaps, were issues through JPMorgan's investment bank and specifically the firm's equity exotics desk.

The plan worked as follows: JPMorgan would issue Madoff-tied notes designed for returns that tracked the performance of a Madoff feeder fund. To make sure, the bank wouldn't be on the hook to pay those investment returns out of its pocket, so JPMorgan made direct investments in Madoff's feeder -- mitigating its exposure to possible obligations.

It all started small. JPMorgan had a policy in place that required special approvals to make an investment of over $100 million in a single hedge fund.

Of course, $100 million eventually wasn't seen as enough exposure or the type of investment needed to generate the fees that JPMorgan's investment bank could earn selling structured equity products.

In June 2007, DoJ documents show that JPMorgan's equity exotics asked for an exception to the $100 million risk limit to meed demand for the structured products it was selling. Specifically, the head of JPMorgan's EMEA equities desk asked that the firm to underwrite approximately $1 billion in Madoff-linked derivatives. In total, JPMorgan could have sunk $1.32 billion of its own capital into Madoff, putting the firm's exposure at $1.14 billion were the value of Madoff feeder funds to fall to zero, according to the DoJ's documents.

On the other hand, if JPMorgan's exotics desk had gotten the go-ahead, they might have generated between $55 million-to-$70 million in fee-based revenue for the products they might have sold.

JPMorgan's risk officers, however, declined to extend the bank's exposure to Madoff without having the ability to do direct due diligence, which Madoff obviously wouldn't allow. "We don't do $1 bio [billion] trust me deals," JPMorgan's chief risk officer said in an email, according to DoJ documents.

Later that June, JPMorgan's chief risk officer allowed the exotics desk to extend its risk exposure to Madoff by an additional $250 million. By September 2008, the bank began to consider redeeming some of its exposure of Madoff feeder funds and in mid-October employees began circulating memo's expressing their concern that Madoff's performance was too good to be true, documents show.

By October, JPMorgan had placed redemption orders for $78 million it had invested into Madoff feeder funds. Between Oct. 1 and Oct. 15, JPMorgan then sought to redeem all of its remaining Madoff exposure, and unwind some of the structured products it had written.

All told, through the fall of 2008, JPMorgan's position in Madoff feeder funds fell from $369 million at the beginning of October to about $81 million by Madoff's arrest on Dec. 11, 2008.

Obviously, it could have been worse... and this from a bank that went on to lose in excess of $6 billion on a similarly complex credit derivatives trade now known as the "London Whale."

On Tuesday, JPMorgan agreed to a deferred prosecution agreement on two counts of fraud and $2.6 billion in total fines. The bank, which has already reserved $23 billion for its disparate legal exposures from the housing meltdown, trading losses and LIBOR-related investigations, said in a Tuesday filing it will boost its litigation reserves by $400 million. Since Tuesday's settlement is not tax-deductible, JPMorgan forecasts a $850 million reduction against its fourth quarter net income.

-- Written by Antoine Gara in New York

Follow @antoinegara

More from Stocks

Stocks Trade Lower as Optimism Wanes Over China Trade Talks

Stocks Trade Lower as Optimism Wanes Over China Trade Talks

Did Trump Just Torpedo the Stock Market Again?

Did Trump Just Torpedo the Stock Market Again?

10 Questions for PayPal Ahead of Its Big Investor Day

10 Questions for PayPal Ahead of Its Big Investor Day

Trump, China Trade, Target and Las Vegas Casinos - 5 Things You Must Know

Trump, China Trade, Target and Las Vegas Casinos - 5 Things You Must Know

9 Stocks Goldman Sachs Thinks Will Blow Wall Street's Performance Away in 2019

9 Stocks Goldman Sachs Thinks Will Blow Wall Street's Performance Away in 2019